The relationship between financial leverage and profitability pelican paper inc

Accounting

P2-20 The relationship between financial leverage and profitability Pelican Paper, Inc., and Timberland Forest, Inc., are rivals in the manufacture of craft papers. Some financial statement values for each company follow. Use them in a ratio analysis that compares the firms’ financial leverage and profitability.

Item Pelican Paper, Inc. Timberland Forest, Inc.

Total assets $10,000,000 $10,000,000

Total equity (all common) 9,000,000 5,000,000

Total debt 1,000,000 5,000,000

Annual interest 100,000 500,000

Total sales $25,000,000 $25,000,000

EBIT 6,250,000 6,250,000

Earnings available for

Common stockholders 3,690,000 3,450,000

a. Calculate the following debt and coverage ratios for the two companies. Discuss their financial risk and ability to cover the costs in relation to each other.

b. Calculate the following profitability ratios for the two companies. Discuss their profitability relative to each other.

c. In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberland’s investors undertake when they choose to purchase its stock instead of Pelican’s?

P5–3 Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:

Expected Expected

Investment return risk index

X 14% 7%

Y 12 8

Z 10 9

a. If Sharon were risk-indifferent, which investments would she select? Explain why.

b. If she were risk-averse, which investments would she select? Why?

c. If she were risk-seeking, which investments would she select? Why?

d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?

P5–4 Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating the possible outcomes, the company made the estimates shown in the following table:

Expansion A Expansion B

Initial investment $12,000 $12,000

Annual rate of return

Pessimistic 16% 10%

Most likely 20% 20%

Optimistic 24% 30%

a. Determine the range of the rates of return for each of the two projects.

b. Which project is less risky? Why?

c. If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk?

d. Assume that expansion B’s most likely outcome is 21% per year and that all other facts remain the same. Does this change your answer to part c? Why?

P4-10 Basic scenario analysis Murdock Paints is in the process of evaluating two mutually exclusive additions to its processing capacity. The firm’s financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows associated with each project. These estimates are shown in the table on page 488.

Project A Project B

Initial investment (CF0) $8,000 $8,000

Outcome Annual cash inflows (CF)

Pessimistic $ 200 $ 900

Most likely 1,000 1,000

Optimistic 1,800 1,100

a. Determine the range of annual cash inflows for each of the two projects.

b. Assume that the firm’ s cost of capital is 10% and that both projects have 20-year lives. Construct a table similar to this for the NPVs for each project. Include the range of NPVs for each project.

c. Do parts a andb provide consistent views of the two projects? Explain.

d. Which project do you recommend? Why?